International Fidelity Insurance Company v. Western Virginia Water Authority - Prepayment As A Material Alteration: How Much Is Too Much?

In the recent case of International Fidelity Insurance Company v. Western Virginia Water Authority, No. 11-00441, 2012 WL 4503191 (W.D. Va. September 28, 2012) the court considered the issue of whether a prepayment or overpayment of a portion of a construction contract sum was sufficiently large to result in the discharge of a surety. In that case, the court ruled that an overpayment of approximately five percent of the contract sum was not large enough.

On May 4, 2009, the Western Virginia Water Authority (the Authority) entered into a contract with Carnell Construction Company (Carnell) for construction and grading work on the Falling Creek Dam Renovation (the Project). The contract sum was $1,827,123.00. The contract provided for monthly progress payments. Carnell was to receive ninety five percent of the approved progress payment and the remaining five percent (the retainage) was to be placed in an escrow account.

On April 6, 2009, International Fidelity Insurance Company (IFIC), as surety, issued a labor and material payment bond (the Bond) on behalf of Carnell to satisfy the claims of any unpaid subcontractors on the Project.

The Authority, Carnell, IFIC and First State Bank (First State) entered into an escrow agreement. The escrow agreement provided that the Authority would pay the five percent retainage unto the escrow account and First State, as the escrow agent, would pay the Authority or Carnell, any amounts as instructed by the Authority. The Authority paid a five percent retainage to First State on each progress payment for a total of $85,823.33. However, the retainage checks that First State received from the Authority did not clearly indicate they were being paid to First State as escrow agent. As a result, when First State received these checks, they were deposited into Carnell’s business savings account. Carnell had been a long time customer of First State.

Carnell completed the Project on June 14, 2011. IFIC then received and paid a claim against the Bond from Ferguson Contractors (Ferguson), one of Carnell’s subcontractors, in the amount of $286,571.44. When IFIC demanded the unpaid contract balances and the retainage from the escrow account, the Authority paid the contract balance, $33,865.98, but could not pay the $85,823.33 that was supposed to be in the escrow account.

As a result, IFIC sued the Authority in the United States District Court for the Western District of Virginia to recover the $85,823.33 and the $286,571.44 that IFIC paid to Ferguson. IFIC and the Authority cross-moved for summary judgment. The court granted IFIC summary judgment on its claim for $85,823.33 but denied IFIC’s claim for $286,571.44 and rendered summary judgment in the Authority’s favor.

The basis for IFIC’s claim for the $286,571.44 payment to Ferguson was that the Authority’s failure to properly retain the contract payments discharged IFIC’s obligation as surety. IFIC claimed that it was entitled to reimbursement because if it had known that the contract retainage was not being withheld, IFIC would have refused to pay Ferguson.

The court noted that the discharge of a surety because of overpayment was recognized in the case law:

Cases in which a surety’s obligations have been discharged generally involve a project owner prepaying or overpaying on a contract to such an extent that it materially altered the surety’s rights and expectations by reducing the contractor’s incentive to complete the project in a timely and satisfactory manner. Substantial prepayment diminishes a key piece of the collateral a surety considers when it decides to enter into a bond agreement with a contractor.

2012 WL 4503191 at ⃰ 6 (citations omitted).

In IFIC’s case the alleged material alteration was the “prepayment” of the retainage, $85,823.22, that should have been held in escrow. This amount was roughly five percent of the $1.8 million contract sum. The court found that the premature payment of five percent of the contract price was, “[S]ubstantially disproportionate to the much larger amounts involved in those cases in which the surety’s obligations were deemed to have been discharged.” Id.

Indeed, in those cases cited by the court which allowed a discharge, Continental Insurance Co. v City of Virginia Beach 908 F. Supp. 341 (E.D.Va. 1995) and Southwood Builders, Inc. v. Peerless Insurance Co., 366 S.E.2d 104 (Va. 1988), the amounts of the payments were significant in relation to the original contract sums. In Continental the court found that prepayment of over half the contract sum constituted a material variation of the contract which thus discharged the surety. 908 F. Supp. at 348. In Southwood the court held that a payment of $31,000 on an original contract sum of $79,500.00 amounted to a material alteration that discharged the surety’s obligations. 366 S.E.2d at 108.

The court concluded that:

The relative insignificance of the $85,823.33 in comparison to the total contract price in this case militates against finding a material alteration.

. . . .

After considering the small size of the prepayment amount, as well as the intentions and expectations of the parties throughout the dispute, the court finds that the Authority’s failure to retain a portion of the Contract price did not amount to a material alteration of IFIC’s contract with Carnell. Thus IFIC’ s claim for the $286, 571.44 will be denied.

2012 WL 4503191 at ⃰ 7.

The surety did not come away empty handed. At the time it paid Ferguson, IFIC could not have expected that anything more than $119,689.31 [$85,823.33 + $33,865.98 = $119,689.31] would be available if it sought to offset its Bond loss from the contract balance and retainage. The court granted summary judgment in the surety’s favor for the $85,823.33. This amount, plus the $33,865.98 that was eventually paid to IFIC, placed the surety in the position that it expected to be in ($85,823.33 in escrow and a contract balance of $33,865.98 held by the Authority) before it paid Ferguson.

This correspondence should not be construed as legal advice or legal
opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult a lawyer concerning your own situation with any specific legal question you
may have.